Traditionally, pensions have been the first source of income individuals go to when it comes to funding their retirement.

However, in 2015/16 George Osbourne changed pension regulations, offering a new option for individuals to consider as part of their retirement planning, and shifting the emphasis on pensions from an income source to an effective estate planning tool.

As a result, depending on your individual circumstances, and the type of pension scheme you are part of, leaving your pension for a longer period of time before you draw it can be a valuable tool for estate planning, whilst helping to mitigate Inheritance Tax (IHT).

Changing pension regulations – relaxation of tax charges for pension funds

Pension regulations have long meant that if an individual dies before the age of 75 without drawing their pension, the funds remain outside the individual’s estate, and are consequently exempt from IHT, and can potentially be passed on to beneficiaries as tax-free income.

Under the old rules, individuals who died after the age of 75, after having begun to take pension benefits, were subject to a 55% exit charge on lump sums paid out to beneficiaries.

This changed in 2015, where new regulations were introduced, meaning there is no tax charges on payments made after a pension holder’s death.

Planning considerations for different types of pension schemes

Defined contribution pension schemes

Under the changed regulations, a pension can be used to give beneficiaries a tax-free income if you die before the age of 75. If you die after 75 the money would be taxed as income when it is withdrawn.

Members of a defined contribution pension scheme can now nominate someone to inherit the unpaid pension fund. This can be any person with no age restrictions, meaning nominees can now have access to income at any age.

There are a number of potential advantages to being able to pass on pension funds, which include:

  • Inherited funds will continue to benefit from tax-free growth until withdrawn by the beneficiary
  • A pension can be used as an intergenerational planning tool to benefit future generations
  • Charities could also be nominated to receive any remaining pension funds tax free on death

Significantly, you could potentially save IHT by leaving your pension untouched and funding your retirement with other assets that do form part of your estate such as ISAs or other types of non-taxable investments. Whilst it would be worthwhile to consider using these assets before looking to take your pension, it is important to remember that these assets do make up part of your estate and could be taxed up to 40% on death.

It is also important to note that if your pension pots exceed the lifetime pension allowance, which is currently £1,073,100, you could be taxed adversely.

Defined benefit/final salary pension schemes

The same flexibilities do not apply to members of defined benefit/final salary pension schemes.

It may be possible to transfer entitlements to a personal pension to benefit from the relaxed rules, but in these circumstances advice from an independent financial adviser should be sought. Whether a transfer will be possible is dependent on the type of defined benefit scheme you are in, and transfers could give rise to additional costs, or disadvantageous terms such as loss of guaranteed income in certain situations.

Planning for the future

Following the change in regulations, pensions can be one of the most tax-efficient ways to pass on wealth.

For that reason, if you are able to, leaving your pension untouched and funding your retirement with other assets can be a valuable estate planning tool to mitigate IHT.

Ultimately, planning around the best use of pensions depends on your individual circumstances, and it is important to seek strategic advice when it comes to pension planning in order to ensure you are planning effectively, and making the right decisions when setting up your portfolio.

Our specialist private client team looks after both families and individuals, providing advice on the most effective, flexible and straightforward ways to plan for your future. If you need advice on pension planning, please don’t hesitate to get in touch today.

Please note: Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from taxation, are subject to change.

Watch our video below where Chartered Financial Planner Mufaddal Travadi, from our group company Smith Cooper Independent Financial Solutions, explains more about pension planning. This video is part of our wider Inheritance Tax planning video series, which can be viewed on our YouTube channel.